Anonymised, illustrative composite. An Ontario buyer wanted its target's sales director to sign a personal covenant and offered to pay her for it — which is exactly what ITA s.56.4(6)'s protection for an employee's covenant does not allow.
At a glance
Meridian Trade Supply Inc., an Ontario distributor, was being sold outright by its two founding shareholders. Neither of them was the reason the buyer wanted the deal — the sales director, Patricia, was. She held every major account relationship personally, owned no shares, and had never been asked to sign a non-compete in nine years with the company. The buyer made a personal restrictive covenant from Patricia a closing condition, and proposed paying her $75,000 directly, on top of her ongoing salary, as the incentive to sign it.
Meridian's counsel flagged that paying Patricia separately for her signature did not just cost $75,000 — it destroyed the one statutory mechanism that would otherwise have let her sign for free without a tax consequence of her own, and left open exactly how the buyer would be treated for the payment it wanted to make.
Proposed payment: $75,000, framed in the term sheet as consideration “for entering into the non-competition and non-solicitation agreement.” That framing, on its own, is what caused the problem.
Section 56.4(2) of the Income Tax Act is a catch-all: it includes in a taxpayer's income “the total of all amounts each of which is an amount in respect of a restrictive covenant of the taxpayer that is received or receivable in the taxation year.” The exceptions in s.56.4(3) are narrow, and Patricia does not fit either of the two that matter on a sale: paragraph (b) and (c) both require the taxpayer to be disposing of a business asset or an eligible interest in the corporation being acquired — a share, a partnership interest, the kind of thing a vendor sells. Patricia is not selling anything. She is an employee being asked to promise not to compete, and neither of the disposition-based exceptions has any application to her at all.
What normally protects an employee in her position is s.56.4(5) and (6), not s.56.4(3). Subsection (5) turns off section 68 — the rule that would otherwise let the CRA deem part of a purchase price to have been paid to whoever gave a valuable covenant, whether or not any cheque was actually written to them. Subsection (6) makes that protection available only if all six of its conditions hold, and two of them are the ones this deal broke: “(e) no proceeds are received or receivable by the individual for granting the restrictive covenant; and (f) the amount that can reasonably be regarded to be consideration for the restrictive covenant is received or receivable only by the vendors.” The instant the buyer proposes to pay Patricia $75,000 for her signature, both conditions fail. There is no version of s.56.4(6) that tolerates paying the covenantor directly.
What this file does and does not resolve. With s.56.4(3) unavailable and s.56.4(5)/(6) defeated by the payment itself, s.56.4(2) includes the $75,000 in Patricia's income in full — there is no capital-gains route open to her either way, because the exemption belongs to a vendor disposing of shares, and she is disposing of nothing. What is genuinely open, and was not resolved on these facts, is the buyer's own deduction for the payment: s.56.4(4)(a) deems an amount to be deductible wages only “if the amount is required because of section 5 or 6” to be included in Patricia's income — that is, only if it is already employment income on ordinary principles, which is a separate, fact-specific question this file has not verified. A payment captured by s.56.4(2)'s own catch-all rather than by s.5 or 6 is not automatically deemed to be wages, and no other paragraph of s.56.4(4) reaches an amount paid to someone who is not a vendor. Treating the buyer's deduction as settled would have been exactly the kind of confident guess this corpus is built to avoid.
The parties dropped the standalone covenant payment entirely. Patricia's non-compete and non-solicitation obligations were folded into an amended employment agreement with the (now buyer-owned) company, tied to a retention bonus payable for continued service rather than framed as consideration for signing a covenant. As ordinary compensation for ongoing employment, that structure sits squarely inside s.5 and s.6 on its own terms — not because of any special election, but because it never touches s.56.4 at all — which gave both sides a result they could actually rely on rather than one built on an unresolved deduction.
Closing on the original structure would have left Patricia with a $75,000 income inclusion she could not shelter, no worse in that respect than a retention bonus — but it would have left the buyer's tax treatment of its own $75,000 payment unresolved at exactly the moment nobody wants an open question: after the money is spent.
The tell was in the term sheet's own wording. The moment a payment to an employee is described as being “for” signing a restrictive covenant, s.56.4(6)'s condition (e) — no proceeds received by the individual — is already broken, no matter how the cheque is later cut.
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